Inflation was front and centre on investors’ minds in 1H 2022
In early 2022, supply-chain bottlenecks which were initially born during the pandemic were still a concern and had been driving good prices higher for several months. The anticipated easing of Covid-led restrictions and the reopening of economies around the world was expected to result in a pick-up in global demand. The recovery in global demand was seen as an additional driver that would push inflation higher. The invasion of Ukraine by Russia in late February was the ultimate catalyst that drove prices and inflation expectations higher as the conflict implied trade sanctions, ultimately resulting in rising commodity prices. The Fed, along with numerous central banks around the world, responded by raising interest rates four times between March and July 2022, bringing its target range for the federal funds rate to 2.25% – 2.5%. In financial markets, rate hikes aimed at taming inflation put pressure on fixed income instruments given the negative correlation between bond prices and yields. In the real economy, higher rates tighten financial conditions by making borrowing more expensive. The concern around higher interest rates is hence that they tend to come at the expense of economic growth. As investors were watching central banks raise interest rates in the first part of 2022, their attention started to increasingly shift from inflationary concerns to recessionary fears.
Emerging market countries are better equipped than during the taper tantrum to withstand an economic slowdown
The economic outlook now looks at risk as high inflation prints, central banks’ tightening cycles, geopolitical tensions and continued supply chain bottlenecks are all weighing on global demand, consumer and business sentiment. Economic predictions now guide to an economic recession in many parts of the world over the short to medium term. A slowing economic activity usually translates in increased corporate default rates and higher bond spreads. In addition, as central banks are pulling back on monetary policy accommodation, the amount of liquidity in the financial system should decline, translating into higher liquidity premiums. Those liquidity premiums usually take the form of higher bid-ask spreads, i.e the difference between the purchase and the sale price for a specific instrument. In addition, the price gap between liquid bonds and more illiquid ones will start to widen.
Whilst a combination of weaker global demand and higher interest rates in the US is likely to weigh on emerging market countries, we believe those economies are in a much better place today than during the taper tantrum of 2013 to withstand a period of economic slowdown. In our view, emerging markets still provide attractive investment opportunities. As mentioned in our previous note on inflation, fewer emerging economies were relying on short-term capital inflows in 2021 to finance their current account deficits than in 2013. In addition, many emerging market central banks took a head start by embarking on a tightening cycle ahead of the Fed in order to tackle inflationary pressures in their countries. Another important point is that corporate balance sheets look, generally speaking, healthier and less levered today than in 2013. Finally, valuations in emerging markets look attractive on a historical basis, i.e prices today look cheaper than their historical average.
Active management remains key in such an environment
In an environment characterised by high inflation and rising yields, like the one witnessed in the first part of 2022, we are of the view that short-term high yield bonds are a segment to focus on. Since high yield bonds tend to be least correlated to moves in risk-free rates, they also suffer the least in a rising rate environment. In addition, as duration is positively correlated to interest rate risk, shorter-dated bonds are more immune to rising yields than their longer-maturity counterparts. As recessionary fears grow, however, we favour investment grade bonds. The rationale behind this view is threefold. First and foremost, investment grade bonds are more tightly correlated to risk-free rates than high yield instruments (as illustrated in the chart below). As markets begin to price in a recession, longer-term interest rates tend to drop as a recession usually entails interest rate cuts. We would therefore expect investment grade bonds to outperform high yield ones in a recessionary environment. Secondly, investment grade bonds tend to be more liquid than high yield ones and we think liquidity should be a key area of focus in environments like the one we are in today. Having a liquid portfolio enables portfolio managers to meet potential outflows swiftly in times of market distress. Lastly, focusing on higher quality credits acts as a protective mechanism in environments where recessionary fears and default risks are mounting.
In the above chart, the blue line illustrates the correlation between the Bloomberg Global Agg Treasuries Index and the Bloomberg AA-rated Global Aggregate Index. The orange line shows the correlation between the Bloomberg Global Agg Treasuries Index and the Bloomberg Global High Yield Index. This chart hence puts forward the higher correlation between treasuries, i.e risk-free interest rates, and investment grade bonds than between treasuries and high yield bonds.
We continue to see numerous dispersions between various parts of the emerging markets world. In terms of fundamentals, net commodity exporters have benefited from rising commodity prices in the better part of 2022, outperforming net commodity importers. For instance, countries like Indonesia and Brazil have seen their terms of trade improve given their net commodity exporter position. However, India and Egypt have been suffering from rising oil and wheat prices as net commodity importers.
On the monetary front, we are seeing a gap between Latin American countries where most central banks have been hiking rates for several months already, and South East Asia where some countries have not even started tightening their monetary policies. Central banks focused on economic recovery have maintained accommodative monetary policies, whilst those focused on containing inflation have favoured raising rates, sometimes at the expense of economic growth.
On the political front, Latin America will be standing out as political uncertainties remain on the horizon. Cabinet reshuffles have been numerous in Peru, Colombia is now run by a new president and elections in Brazil will take place later this year. With regard to corporate fundamentals, issuers displaying high levels of debt will be more vulnerable to higher interest rates than peers with less levered balance sheets. We also expect companies with robust cost management policies in place to outperform peers given a backdrop of rising costs and persistent supply-chain disruptions. In addition, financial institutions that can pass along rate hikes to their customers will tend to benefit from a rising rate environment.
With so many dispersions on the horizon, we believe active management will be key as it enables portfolio managers to focus on attractive opportunities and reduce exposure to instruments bearing higher risk or displaying less appealing valuations.
In our view, fundamentals of emerging market sovereigns and corporates are stronger today than they were during the taper tantrum of 2013. We thus expect those issuers to be better suited to sustain a period of economic slowdown. In addition, bond valuations in Emerging Markets look attractive relative to historical standards. Finally, the wide range of dispersions within the asset class offers numerous attractive opportunities for active portfolio managers.
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